Imagine a big manufacturing company with all its moving components - a team of administrators, a workforce that manufactures, a crew that procures the necessary raw materials, different units of regulators, marketing department, supply, and distribution chain.
Given the enormity of the company, gaining meaningful insights into its functioning and gauging its efficiency can be a daunting task. This is where financial modeling comes into play, and hence the growing popularity of financial technology courses among the newer generation of finance students.
To cater to the growing demand of the online fintech program, Imarticus Learning has come up with a Financial Analysis Prodegree in collaboration with KPMG that offers young professionals a 180-hour financial planning and analysis course covering research on equity and valuation, financial modeling, and accounting. This article will give you an elementary understanding of financial modeling and how it will be a breakthrough for the new generation of finance trends.
What is a financial model?
A financial model is a simple tool that utilizes any built-in spreadsheet software, such as MS Excel, to forecast the financial performance of any business in the future. It relies on the performance history and future performance assumptions to prepare a balance sheet, income, cash flow statements, and supporting schedules.
This dynamically connected financial model is called a 'Three Statement Model'. It is the base on which we can build more advanced models, like Mergers and Acquisitions (M&A), Leveraged-Buyout (LBO), Discounted Cash Flow Analysis (DCF model), and other types of financial models.
How is a financial model used?
Company executives rely on the financial model to aid them in taking decisions regarding the analysis of the company finances. Some of the significant decisions that are based on such models are:
- Making organic business expansions
- Divesting business units and assets
- Raising and allocating capital
- Making acquisitions
- Budgeting and forecasting
- Management accounting
- Valuing a business
- Financial statement analysis
A step-by-step guide of building a financial model
While building a financial model requires lots of relevant data, assessing them and understanding them comprehensively, using financial tools, and auditing and stress-testing. However, a generic but step-by-step breakdown of building a financial model is provided below:
- Every financial model begins with an in-depth study of the past financial statements and reverse-engineering the data to forecast gross margins, fixed costs, revenue growth rate, fixed costs, among others.
- The next step is to start an income statement to compute the revenues, operating expenses, gross profit, etc. With that, you can also begin to fill in the balance sheet.
- The third step compromises building supporting schedules for capital assets like Property, Plant & Equipment (PP&E), and also for interest and debt.
- Use the reconciliation method to build the cash flow statement by adding depreciation and starting with the net income.
- After completing the Three Statement Model, perform the Discounted Cash Flow (DCF) analysis by evaluating your business value and calculating free cash flow.
- Assess the risk of an investment or plan your business accordingly with different assumed scenarios by adding sensitivity analysis.
- Build graphs and charts of the financial model to communicate the output with the clients.
- Test your financial model by stress-testing it against extreme scenarios to check whether your model behaves as expected.
Even a cursory understanding of financial modeling will help you understand that it is imperative for most modern business giants. A global pandemic, recession, inflation, and other economic factors have already bolstered the need for financial models to grow businesses. Enroll in the Financial Analysis course of Imarticus Learning to join the new generation of finance trends.